Retirement raidings

Americans are borrowing record amounts from retirement savings. Should 401(k) loans be limited?

In good news for Americans’ retirement security, new data shows Americans might finally be saving more for retirement. But Americans are also borrowing more from their retirement accounts, thereby potentially erasing a big chunk of these gains.

Over the 12 months ending in June 2015, Americans on average socked away a record high of $10,180 into retirement savings, according to recent data from Fidelity Investments.

But at the same time, more than 1 in 5 Americans – or 21.9 percent –have an outstanding loan against their 401(k). According to Fidelity, the average balance for these loans at the end of June was $9,720 – up from $9,500 a year ago.

Paradoxically, says Doug Fisher, Senior Vice President at Fidelity Investments, larger account balances might be prompting bigger loans. “I call it the ‘false sense of continued prosperity’ effect,” he said. “When 401k balances go up because the stock market rises, people feel like they have more wealth and borrow more.”

The actual result, however, could be significant long-term damage to Americans’ retirement security.

For one thing, Fisher says, many workers cut back their retirement contributions or stop saving altogether while they’re paying back a loan – often for as long as two years. This is particularly damaging for younger workers, Fisher said. “The insidious effect here is that if you’re in your mid-20s and early 30s, you’re reducing savings at a point in your career when early savings matter,” said Fisher. According to Fidelity’s data, 15.7 percent of millennials had an outstanding loan against their 401(k)s as of June 2015, with an average loan of $5,970.

Another problem is default. Under current tax law, any amounts that a worker fails to pay back are considered “early distributions” from the 401(k). In addition to paying income taxes on the amount still due, borrowers also face a 10 percent penalty.

These penalties are high enough that most 401(k) borrowers pay back their loans. Nevertheless, a recent study by the Wharton School’s Pension Research Council estimates that 401(k) loan defaults total as much as $6 billion a year. Roughly 1 in 10 loans are not repaid, the study further concludes, particularly if a worker leaves a firm. In fact, the study finds, “a vast majority – 86 percent – of employees who leave their jobs with a plan loan outstanding do default, exposing them to both penalty and any income tax due.”